Tutorials Archives - Financial Memos

The accounting for bonds is a fascinating area of study in accounting and it enables us to get a bit into finance. And for accountants, knowing how bonds should be correctly accounted for is critical for many businesses today. So today's tutorial, part of our accounting tutorial series, we will be looking at a retiring bonds journal entry example that will help explain all that goes on with the debits and credits. We have written this guide to be as comprehensive as possible, including the bond formulas and calculations. So if we have left something out that you need to know, please get in touch through our Contact Us page. For those with little time on their hands, there is no quick answer for the journal entry as it depends on whether the bond was initially issued at a premium or discount and whether there is a gain or loss on retirement. If you want to skip the theory jump down to the journal entry example for the debits and credits. What is a Bond? A bond is just a promise to pay another party two things; one, a set rate of interest on specific dates; and two, repay them their principal on maturity. Bonds don't normally have early repayment options for holders, although, the bond can normally be sold onto another buyer - with no involvement from the issuer. Like any other liability on the balance sheet (statement of financial position), a bond is normally classified as non-current as they tend to be issued on five to ten-year maturities. Of course, this is apart from the year before maturity, where that classification would change to current. Bonds are best known as being issued by companies and central governments; however, not-for-profit organisations also use them for their debt funding requirements. The most famous types of bond issues are the United States Treasury Bills (or T-Bills) and the British Gilts issued by HM Treasury Debt Management Office. There are three key characteristics that are important to know for accounting about bonds payable: the interest payable on the bonds is called the coupon rate. The bond will set out the percentage, how it is to be compounded and when it is to be paid;as mentioned above, the bond will have a set maturity date for repayment, and;once issued on the primary market a bond can be freely traded through a secondary market, with the original purchaser not having to hold until maturity. For example, the Gilts issued by HM Treasury Debt Management Office are traded on the London Stock Exchange. Why Retire a Bond Early? There are three main reasons why bonds will be retired by the issuer. The most obvious is because the bonds have reached their maturity date, and the bondholders want their money back. The second reason is often seen in a falling interest rate environment where the issuer wants to replace the bonds with cheaper debt. And the third reason is the lack of alternative investment opportunities, which relates to the firm's cost of capital. Maturity of the Bonds As we mentioned in the section above under "What is a Bond", all issued bonds will have a maturity date. At that time, the holder of the bond is repaid the face value of the debt. In exchange for payment of the face value, the holder gives up their debt claim, and the instrument is retired. Changing Cost of Debt Where the issuer is in a falling interest rate environment, they have an incentive to replace higher interest rate debt with lower interest rate debt. The falling price of the debt could be caused by one of a number of factors, from a general falling interest rate across all debt markets to the firm having an upgrade in its credit rating, making it cheaper to borrow money. In any case, to improve both liquidity and gearing, an issuer, in this case, may well replace bonds currently issued with new debt from a new funding round. We'll get into how they could go about this in the section below. Changing Cost of Capital The third reason for retiring bonds is the firm has no better alternatives for its excess or spare capital. It may have built up surplus funds from significantly improving operations, additional capital or asset disposals and so needs to put this money to use. After having funds set aside as reserves, just like you and I should do in our own personal lives, a firm will then need to deploy the surplus funds. And like us, a firm will want to deploy these funds where the return is highest for them - taking into account weight risks and short and long-term goals. If the deployment of funds back into the business, buying into another business, share buy-backs, etc. are not available for sufficient return, the retirement of debt is another option. The beauty of replaying debt is the returns on the funds is guaranteed. If a firm has bonds issued at a coupon rate of 4 per cent, in repaying this debt, they have a guaranteed return on that money of 4 per cent. This would then be compared to other options, that although may offer higher percentages, the return is not guaranteed. In other words, it is not risk-free - as debt repayment is. Even US T-Bills are not risk-free (especially these days). What is also important to mention here is the retirement of old debt for new debt isn't without cost. We sometimes forget in the world of debits and credits, these business processes take time, and so take money. If you would like more information on how debt issuance costs are accounted for, we have a whole tutorial on this - which you can find through this link. The Three Ways Bonds are Retired On Maturity The simplest journal entries we will look at in the examples below will be the retirement of bonds when they reach maturity. The reason why they are the simplest as all discounts or premiums and debt issuance costs have now been amortised, and all we are left to deal with is carrying value being the same as the bonds' par value (or face value). In this example, we will also look at the situation of bonds that are convertible into equity. Call Options The second scenario we will cover in the examples below are callable bonds. These are bonds that have been issued with a call option for the issuer to buy the bonds back. The price at which the call is exercised is the par value plus a premium to the bondholder - reflecting the loss of interest of the remaining life of the bond. The Open Market And the third scenario we will work through is where the issuer enters the secondary market to buy their bonds back. In this case, the issuer is paying the current market price for the bonds, whatever that price is at the time. Retiring a Bond Early: Discounts, Premiums, Losses and Gains We are almost at the examples and debits and credits. But before getting stuck into an example and the journal entries, we need to cover a few more things; and there are discounts, premiums and losses and against. Each is discussed below. Bond Discounts If bonds were originally issued at a discount, and we retire these instruments early, we are going to have to account for a Discount on Bonds Payable Issue account. This is a contra account setup at bond issue and being amortised over the life of the bond. If you are interested in working through the calculations and the journal entries for this, we have a whole tutorial covering these discounts, and you can find that here. For a quick summary, how this account comes about is when the bonds are issued at an interest rate (or coupon rate) lower than the prevailing market rate for that bond grade. Below is the journal entry from the article we mentioned above: DateAccount NameDebitCreditJuly 1Bank1,000,385Discount on Bonds Payable Issue149,615Bonds Payable1,150,000 You can see that the amount of money received into the Bank account is less than the Bonds Payable liability created. We can see that difference is then recorded in the Discount on Bonds Payable Issue, which we then amortise over the bonds' lives. And it's this account we are going to have to deal with below. Bond Premiums We next move onto bond premiums. In this scenario, a firm has issued bonds at an interest rate higher than the prevailing equivalent rate, which bondholders are prepared to pay a premium for. When we are facing this situation, we have to deal with a Premium on Bonds Payable Issue account, which is an adjunct account. We also have a tutorial that deals with bond premiums, and you can find all the information here. Taken from our bond premiums article, the journal entry below shows the creation of the bond issue when issued at a premium. The amount received into the Bank account is greater than the Bonds Payable liability account created. And this difference is the adjunct account Premium on Bonds Payable Issue credit entry that is then amortised over the life of the bonds' issue. DateAccount NameDebitCreditOct 1Bank2,011,251Premium on Bonds Payable Issue271,251Bonds Payable1,740,000 Losses and Gains The final issue to deal with in this section is about the losses or gains generated at the time of early bond retirement. Remember, these losses and gains only relate to when bonds are retired before maturity. The reason for this is the carrying price and the coupon price is the same at maturity; there are no future interest payments to be made, and it's purely the settlement of the debt position. However, when a firm decides to acquire the bonds back before maturity, a loss or gain position will normally be generated, and this is what we will have to account for. A good question at this point, though, is how does a gain or loss arise? Well, let's have a quick look at what we have. There is a carrying value, which is bond issue price adjusted for any premium or discount and any less associated unamortised issuance costs. If the firm pays the price above the carrying value of the debt, then they are incurring losses as the settlement of the debt is costing more than the net liability figure is on their balance sheet. But, if they are able to acquire the debt for less than the carrying value, they have been able to settle the liability figure on the balance sheet at a cheaper price. Therefore the firm has gained on the exchange. We'll work through this in the examples below so you can see the calculations and journal entries. Journal Entry Example for Retiring a Bond Early Having gone through quite a bit of theory, it's now time to look at the debits and credits - it's the fun of the work. As they say, an accountant who doesn't like the debits and credits is an economist in disguise. Or, as I say about some of my colleagues who don't like the taking off or landing bit, they probably shouldn't be airline pilots. But that is for another article, perhaps one day. The first scenario will we look at is the settlement of bonds outstanding on their maturity date. On Maturity Taking from our article that looked at the bonds being issued at a discount, ABC Ltd issued 115 10-year $10,000 bonds. Come June 30 (10 years later), the bonds are now maturing, and the bondholders are due back the face value of the instruments. So ABC accounts team would prepare a journal entry like the one below: DateAccount NameDebitCreditJune 30Bonds Payable1,150,000Bank1,150,000 All very straightforward. We have a debit to the Bonds Payable account of $1,150,000, which reduces this balance down to $0. And this is achieved through the credit to the Bank account, reflecting the payment to the bondholders for the face value of the debt they held. So this journal entry shouldn't have contained any surprises as it is the same for the repayment of any liability balance. We now move onto the repayment situations before the maturity date of the bonds. Retirement of Bonds Before Maturity Bonds Issued at Discount Loss on Retirement of Bonds On July 1, ABC Ltd issued bonds at a discount because while the coupon rate was a healthy 7 per cent, the prevailing equivalent market rate was 9 per cent. So bondholders were only prepared to buy the bonds at a discount. Eight years later, ABC Ltd decides it wishes to retire this debt at the end of year eight. However, because the prevailing market interest rate has subsequently fallen over the years (now sitting at 5 per cent), the bonds have increased in price and now trade at a premium. Consequently, ABC Ltd has to pay "over the odds" for their earlier retirement. Below is an extract from the carrying value calculation. At the end of period 16 (interest was payable every six months), we have a carrying value of $1,108,695 (if you would like an explanation of how this table is put together, please follow this link, which takes you to the article). Now we know the carrying value, we can have a look at the price ABC Ltd will be paying. Fortunately for us, bond valuations are pretty standard, and the formula to come up with the price is: Bond price = Principal / (1 + i) n + Interest x ((1 - 1 / (1 + i)n ) / i) principal = face value of the bondinterest = interest amount per payable periodi = the market interest raten = number of interest payable periods over the life of the bond So in our example the bond price is: principal = $10,000interest = ($10,000 x 7%) / 2 = $350i = 5% (market interest rate)n = 4 years x 2 payments per year = 8 payable periods Bond price = $10,000 / (1 + 5% / 2)8 + $350 x ((1 - 1 / (1 + 5%)8 / (5% / 2)) Bond Price = $10,717 If we take one more step, we can then work out the loss that ABC will have to book in the journal entry. ANC has 115 bonds on issue, so the calculation for the total loss it will incur is: (bond price - bond carrying value) x bonds on issue Using this formula, we would calculate the loss on retirement as: ($10,717 - ($1,108,695 / 115)) x 115 = $123,760 With all of this information, ABC's accounts team would prepare the following journal entry: DateAccount NameDebitCreditJune 30Bonds Payable1,150,000Loss on Bond Retirement123,760Discount on Bonds Payable Issue41,305Bank1,232,455 The first debit entry to Bonds Payable reflects the full settlement of the liability (115 bonds x $10,000). The second debit to Loss on Bond Retirement is the difference between the carrying value and market value at the end of year eight. The credit to the Discount on Bonds Payable Issue account is the amount of unamortised discount (as per the table above). And the payment from the Bank account reflects the full settlement of the bonds, including the premium the holders were now demanding. Gain on Retirement We now turn our attention to the situation of where interest rates had risen from when the bonds were issued, and ABC will be able to book the gain on bond retirement. In our continuing example using ABC Ltd, this time, the equivalent interest rate has risen from 9 per cent at issue date to 11 per cent, eight years later. We already have our carry value of $1,108,695, so all we need now is the prevailing market value of the bonds. As before we'll use this formula: Bond price = Principal / (1 + i) n + Interest x ((1 - 1 / (1 + i)n ) / i) In this new scenario we would have a bond price of: principal = $10,000interest = ($10,000 x 7%) / 2 = $350i = 11% (market interest rate)n = 4 years x 2 payments per year = 8 payable periods Bond price = $10,000 / (1 + 11% / 2)8 + $350 x ((1 - 1 / (1 + 11%)8 / (11% / 2)) Bond Price = $8,733 We then have a gain on retirement calculation of: (bond price - bond carrying value) x bonds on issue And this formula would mean a gain of: ($8,733 - ($1,108,695 / 115)) x 115 = ($104,400) Being the market price is less than the carrying value, a negative number, we know this will be a gain on the settlement of the bonds for ABC Ltd. ABC's accounts team would then go ahead and prepare the following journal entry on the settlement date. DateAccount NameDebitCreditJune 30Bonds Payable1,150,000Gain on Bond Retirement104,400Discount on Bonds Payable Issue41,305Bank1,004,295 As we did with the loss on retirement, the debit entry is to the Bonds Payable account, reducing this balance to $0. We now have a credit to the Gain on Bond Retirement account, reflecting the benefit ABC received when it settled the liability in the market for less than the carrying value. And as before, we have a $41,305 credit to the Discount on Bonds Payable Issue, reflecting the unamortised balance at the end of eight years. The credit to the Bank account is the cash ABC has to payout to current bondholders for the settlement. Bonds Issued at Premium Loss on Retirement We now change the example a little to match up with our article that has gone through all of the calculations for when bonds are issued at a premium. As we referenced before, if you would like to read more on this specifically, please follow this link. On October 1 ABC issued 87 ten-year $20,000 bonds, raising $2,000,000 for some warehouse expansion. The bonds carried a coupon rate of 7 per cent when the equivalent market rate was 5 per cent. The initial journal entry raised by ABC's accounts team was: DateAccount NameDebitCreditOct 1Bank2,011,251Premium on Bonds Payable Issue271,251Bonds Payable1,740,000 Come eight years later, and ABC's Board has decided to retire this debt as interest rates are now as low as 3 per cent. The repayment will come from cash reserves rather than the issuing of new debt. As we did before, we now have to establish what the carrying value of the bonds is in ABC's accounts and what the market price of the bonds will be. As a refresher, the formula we will be using is: Bond price = Principal / (1 + i) n + Interest x ((1 - 1 / (1 + i)n ) / i) principal = face value of the bondinterest = interest amount per payable periodi = the market interest raten = number of interest payable periods over the life of the bond So in our example the bond price is: principal = $20,000interest = ($20,000 x 7%) / 2 = $700i = 3% (market interest rate)n = 4 years x 2 payments per year = 8 payable periods Bond price = $20,000 / (1 + 3% / 2)8 + $700 x ((1 - 1 / (1 + 3%)8 / (3% / 2)) Bond Price = $22,994 We then have a gain on retirement calculation of: (bond price - bond carrying value) x bonds on issue And this formula would mean a gain of: ($22,994 - ($1,805,458 / 87)) x 87 = $195,202 With all the information needed, ABC's accounts team would prepare a journal similar to that set out below. DateAccount NameDebitCreditJune 30Bonds Payable1,740,000Loss on Bond Retirement195,202Premium on Bonds Payable Issue65,458Loss on Bond Retirement182Bank2,000,478 The first debit entry reflects the elimination of the Bonds Payable liability through the debt repayments. The debit to the Loss on Bond Retirement reflects the difference between the carrying value and the market price. While the third debit is obtained from the Bonds Value table, we used above and is the unamortised balance of the premium originally generated when the bonds were issued. The fourth debit is generated through round errors in the calculations. We don't normally net off amounts like this in accounting; however, applying a credit to the Loss on Bond Retirement account reflects a better net position for ABC, rather than placing this figure in another account. And the credit to the Bank account reflects the repayment to bondholders. Gain on Retirement If you have made it this far, congratulations; we are now at the final calculations and journal entry. Rather than ABC incurring a loss on the debt retirement, they have generated a profit or gain. This time equivalent market interest rates have risen, from 5 per cent when the bonds were issued to 9 per cent. Therefore the bonds have fallen in value over time in the market, and so ABC should be able to retire the debt for an amount less than the current carrying value. We'll be using our normal formula for bond price and then the gain or loss on retirement. First off is the bond price calculation. Bond price = Principal / (1 + i) n + Interest x ((1 - 1 / (1 + i)n ) / i) principal = face value of the bondinterest = interest amount per payable periodi = the market interest raten = number of interest payable periods over the life of the bond So in our example the bond price is: principal = $20,000interest = ($20,000 x 7%) / 2 = $700i = 9% (market interest rate)n = 4 years x 2 payments per year = 8 payable periods Bond price = $20,000 / (1 + 9% / 2)8 + $700 x ((1 - 1 / (1 + 9%)8 / (3% / 2)) Bond Price = $18,681 We then have a gain on retirement calculation of: (bond price - bond carrying value) x bonds on issue And this formula would mean a gain of: ($18,681 - ($1,805,458 / 87)) x 87 = ($180,211) Now we have both the bond price and book value figures, ABC's accounts team can prepare the following journal. DateAccount NameDebitCreditJune 30Bonds Payable1,740,000Premium on Bonds Payable Issue65,458Gain on Bond Retirement15Premium on Bonds Payable Issue180,211Bank1,625,232 Let's deal with the rounding error that sticks out like a sore thumb. Again, because we have been rounding all the calculations to zero decimal places, these roundings tend to compound as calculations go on. So in our case, we have a $15 imbalance between the total debits and credits. So I've added this to the Gain on Bond Retirement account to reflect the net benefit to ABC. By working this example back through, and the original calculations from our other article, using two decimal places, these errors pretty much disappear. As we have with the loss situation, the Bonds Payable debit entry reflects the full retirement of this debt in ABC's accounts. The debit to the Premium on Bonds Payable Issue account is the elimination of the unamortised balance of this balance. The second credit entry to the Premium on Bonds Payable Issue account reflects the difference between the current market price and the carrying value of the bonds. And finally, the credit to the Bank account is the payout to bondholders on June 30. Conclusion It's been a long tutorial, this one. But there is a lot to cover when dealing with bonds and how they should be accounted for. We have included the calculations as we think this is important if you are to properly understand how we get to the figures for the debits and credits. In the real world or in an exam, these figures may well be provided for you; but knowing how they are generated is still important for the accountant. We'll have some more articles in the future dealing with bonds and their accounting, so keep an eye for those if this is of interest to you. As of writing this tutorial, we have comments turned off at the moment, so if you would get in touch please use the Contact Us or Ask a Question pages.